Jane Young, CFP, EA
It’s always a challenge to balance between current obligations and saving for retirement. A good start toward meeting your retirement goals is to get your financial house in order. Create a spending plan that helps you live below your means. Maintain an emergency fund of at least four months of expenses and pay off high interest consumer debt. Establish a habit of saving at least 10% of your income. If you are getting a late start, you may need to save 15-20% of your income.
Develop a retirement plan to determine how much you need to save on a monthly basis and how large a nest egg you will need to comfortably retire. There are many on-line calculators available to help you run retirement numbers. However, they are only as accurate as the data that you input and the assumptions that the model uses. You may want to hire a fee-only financial planner to run some figures for you.
Work toward maximizing contributions to your employer’s retirement plan; take advantage of any employer match that may be provided. Once you have contributed up to the level of your employer’s match, consider contributing to a Roth IRA. A painless way to steadily increase your contribution percentage is to increase your contribution whenever you get a raise. If you are self-employed, or your employer doesn’t offer a retirement plan, contribute to a SEP, Simple or an IRA. If you are maxed out, increase your contributions as the maximum contribution limits increase or you become eligible for a catch-up contribution at age 50.
Invest your retirement funds in a diversified portfolio made up of a combination of stock and bond funds that invest in companies of different sizes, in different industries and in different geographies. Generally, your retirement savings is long term money, so avoid emotional reactions to make sudden changes based on short term market fluctuations. Develop an investment plan that meets your timeframe and investment risk tolerance and stick to it.
Don’t use your retirement funds as a savings account for other financial objectives. Unless you are in a dire emergency, don’t take distributions or borrow against your retirement funds. When you change jobs, don’t cash out your retirement plans. Roll your funds over to an IRA or a new employer’s plan. Avoid sacrificing your retirement savings to fund college education for your children.
As you near retirement age, there are several ways to stretch your retirement dollars. Retirement doesn’t have to be all or nothing. Consider a gradual step down where you work a few days a week or on a project basis. Try to time the payoff of your mortgage with your date of retirement. Consider downsizing to a smaller home or moving to a more economical area. Establish a retirement spending plan that provides funds for things you value and helps you avoid frivolous spending on things that don’t really matter.
Jane Young, CFP, EA
Many large employers have started offering employees the choice between a traditional 401(k) and a Roth 401(k). However, only a small percentage of employees have elected to contribute to a Roth 401(k). The primary difference between the two plans is when you pay income taxes. When you contribute to a traditional 401(k) your contribution is currently tax deductible, but you must pay regular income taxes on distributions taken in retirement. Contributions to a Roth 401(k) are not currently deductible, but you pay no income taxes on distributions in retirement. As with your traditional 401(k), your employer can match your Roth 401(k) contributions, but the match must go into a pre-tax account.
There are several differences between a Roth 401(k) and a Roth IRA. In 2014, annual contributions to a Roth IRA are limited to $5,500 plus a $1,000 catch-up contribution if you are 50 or over. Contribution limits on Roth 401(k) plans are much higher at $17,500 plus a $5,500 catch-up contribution, if you are 50 or over. Additionally, there are income limitations on your ability to contribute to a Roth IRA, and there no income restrictions on contributions to a Roth 401(k). Additionally, upon reaching 70 ½ you must take a required minimum distribution from a Roth 401(k). You are not required to take a distribution from a Roth IRA at 70 ½. However, you do have the option to transfer your Roth 401(k) to a Roth IRA prior to 70 ½ to avoid this requirement.
The decision on whether to invest in a Roth or traditional 401(k) depends primarily on when you want to pay taxes. If you are currently in a low tax bracket and believe you will be in a higher tax bracket in retirement, a Roth account may be your best option. On the other hand, if you are currently in a high tax bracket and you think you may be in a lower tax bracket in retirement, a traditional 401(k) could be your best option. A Roth 401(k) is generally most appropriate for younger investors who are just getting started in their careers or someone who is experiencing a low income year. People who are in their prime earning years may be better off taking the current tax deduction available with a traditional 401(k).
Unfortunately, it’s difficult for most of us to know if our tax bracket will increase or decrease in retirement. It is also hard to know if tax rates will increase before we reach retirement. From a historical perspective, tax rates are currently low and some believe future rates will be increased to help cover the rising federal debt. Amid this future uncertainty, your best option may be to split your contribution between a Roth and traditional 401(k). This will give you some tax relief today and some tax diversification in retirement.
Jane Young, CFP, EA
One of the biggest decisions associated with saving for retirement is choosing between a Roth IRA and a Traditional IRA. The primary difference between the two IRAs is when you pay income tax. A traditional IRA is usually funded with pre-tax dollars providing you with a current tax deduction. Your money grows tax deferred, but you have to pay regular income tax upon distribution. A Roth IRA is funded with after tax dollars, and does not provide a current tax deduction. Generally, a Roth IRA grows tax free and you don’t have to pay taxes on distributions. In 2013 you can contribute up to a total of $5,500 per year plus a $1,000 catch-up contribution if you are over 50. You can make a contribution into a combination of a Roth and a Traditional IRA as long as you don’t exceed the limit. You also have until your filing date, usually April 15th, to make a contribution for the previous year. New contributions must come from earned income.
There are some income restrictions on IRA contributions. In 2013, your eligibility to contribute to a Roth IRA begins to phase-out at a modified adjusted gross income of $112,000 if you file single and $178,000 if you file married filing jointly. With a traditional IRA, there are no limits on contributions based on income. However, if you are eligible for a retirement plan through your employer, there are restrictions on the amount you can earn and still be eligible for a tax deductible IRA. In 2013 your eligibility for a deductible IRA begins to phase out at $59,000 if you are single and at $95,000 if you file married filing jointly.
Generally, you cannot take distributions from a traditional IRA before age 59 ½ without a 10% penalty. Contributions to a Roth IRA can be withdrawn anytime, tax free. Earnings may be withdrawn tax free after you reach age 59 ½ and your money has been invested for at least five years. There are some exceptions to the early withdrawal penalties. You must start taking required minimum distributions on Traditional IRAs upon reaching 70 ½. Roth IRAs are not subject to required minimum distributions.
The decision on the type of IRA is based largely on your current tax rate, your anticipated tax rate in retirement, your investment timeframe, and your investment goals. A Roth IRA may be your best choice if you are currently in a low income tax bracket and anticipate being in a higher bracket in retirement. A Roth IRA may also be a good option if you already have a lot of money in a traditional IRA or 401k, and you are looking for some tax diversification. A Roth IRA can be a good option if you are not eligible for a deductible IRA but your income is low enough to qualify for a Roth IRA.